theory of the firm : revenue and cost functions foundation microeconomics part 1 of 3

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Theory of the Firm : Revenue and Cost Functions Foundation Microeconomics Part 1 of 3

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Page 1: Theory of the Firm : Revenue and Cost Functions Foundation Microeconomics Part 1 of 3

Theory of the Firm :

Revenue and Cost Functions Foundation MicroeconomicsPart 1 of 3

Page 2: Theory of the Firm : Revenue and Cost Functions Foundation Microeconomics Part 1 of 3

MARK CLEARYFOUNDATION MICROECONOMICS

Photograph tutor

Page 3: Theory of the Firm : Revenue and Cost Functions Foundation Microeconomics Part 1 of 3

Key Concepts• Costs: Fixed, Variable, Total, Average,

Marginal• Price taker, price maker• Profit • Profit maximisation

Page 4: Theory of the Firm : Revenue and Cost Functions Foundation Microeconomics Part 1 of 3

Theory of the FirmCosts: charges incurred for the use of resources.

Short Run: at least one factor of production is fixed

Long Run: all factors of production are variable.

Fixed Costs: costs that are independent of the level of activity of the firm, has to be paid for regardless of whether or not it is used.

E.g. Rent , Business rates

Page 5: Theory of the Firm : Revenue and Cost Functions Foundation Microeconomics Part 1 of 3

Fixed Costs

0 50 100 150 200 250 300 350 400 450-100

100

300

500

700

900

1100

1300

1500 Fixed Costs

Output

Cos

ts £

000

Page 6: Theory of the Firm : Revenue and Cost Functions Foundation Microeconomics Part 1 of 3

CostsVariable Costs: Rise with outputNo output = No V.C.E.g. raw materials, wages, transportTotal Costs: the summation of all

the firms costs. TC = TVC + TFC

Page 7: Theory of the Firm : Revenue and Cost Functions Foundation Microeconomics Part 1 of 3

Variable Costs

Page 8: Theory of the Firm : Revenue and Cost Functions Foundation Microeconomics Part 1 of 3

CostsVariable Total

Output Fixed Cost Cost Cost

(units) (£000) (£000) (£000)

0 600 0 600

40 600 150 750

80 600 300 900

130 600 450 1050

190 600 600 1200

260 600 750 1350

310 600 900 1500

345 600 1050 1650

380 600 1200 1800

390 600 1350 1950

410 600 1500 2100

Page 9: Theory of the Firm : Revenue and Cost Functions Foundation Microeconomics Part 1 of 3

Total Costs

Cost

£

q

TC

TVC

FC

Page 10: Theory of the Firm : Revenue and Cost Functions Foundation Microeconomics Part 1 of 3

Costs• Average Total Cost: the firm’s average cost per unit

produced. ATC = TC/Q

• Average Variable Cost: AVC = TVC/Q

• Average Fixed Cost: AFC = TFC/Q

• Marginal Cost: rTC/rQ

Page 11: Theory of the Firm : Revenue and Cost Functions Foundation Microeconomics Part 1 of 3

Cost

Average fixed cost

Marginal Cost

Average Total Cost

Average variableCost

Cost Functions

Quantity

Page 12: Theory of the Firm : Revenue and Cost Functions Foundation Microeconomics Part 1 of 3

Variable Total ATC AVC AFC MC

OutputFixed Cost Cost Cost

(units) £0 £0 £0 0 600 0 600 600

40 600 150 750 18.8 3.8 15 3.880 600 300 900 11.3 3.8 7.5 3.8

130 600 450 1050 8.1 3.5 4.6 3.0190 600 600 1200 6.3 3.2 3.2 2.5260 600 750 1350 5.2 2.9 2.3 2.1310 600 900 1500 4.8 2.9 1.9 3.0345 600 1050 1650 4.8 3 1.7 4.3380 600 1200 1800 4.7 3.2 1.6 4.3390 600 1350 1950 5 3.5 1.5 15.0410 600 1500 2100 5.1 3.7 1.5 7.5

Page 13: Theory of the Firm : Revenue and Cost Functions Foundation Microeconomics Part 1 of 3

Theory of the Firm 1:

Revenue and Cost Functions End of Part 1

Page 14: Theory of the Firm : Revenue and Cost Functions Foundation Microeconomics Part 1 of 3

RevenueTotal Revenue: total received from the sale of

output; TR = Price x Quantity that is TR = P x QProfit: the difference between income and

expenses; π = Total Revenue – Total CostsMarginal Revenue: the additional income gained

by selling one addition unit MR= rTR / rQAverage Revenue: the firm’s average revenue per

unit sold; AR = TR/Q

Page 15: Theory of the Firm : Revenue and Cost Functions Foundation Microeconomics Part 1 of 3

Price Maker revenue curves:

Total revenue

£

£q

q

Average revenue and marginal revenue

D = ARMR

Page 16: Theory of the Firm : Revenue and Cost Functions Foundation Microeconomics Part 1 of 3

Price taker revenue curves:

Total revenue

£

£q

q

P

Average revenue and marginal revenue

TR

D = AR = MR

Page 17: Theory of the Firm : Revenue and Cost Functions Foundation Microeconomics Part 1 of 3

Theory of the Firm 1:

Revenue and Cost Functions End of Part 2

Page 18: Theory of the Firm : Revenue and Cost Functions Foundation Microeconomics Part 1 of 3

Theory of a Firm: Profit Profit: the difference between income and expenses; π = TR - TC

Normal Profit: covering all costs, without making a surplus; thus effective π = 0

Supernormal Profit: cover all costs and make a surplus; π > 0

Loss: Not able to cover costs; π < 0

Page 19: Theory of the Firm : Revenue and Cost Functions Foundation Microeconomics Part 1 of 3

£

Output

Total Cost

Total Revenue

Profit

Q*

Theory of a Firm: Profit

Page 20: Theory of the Firm : Revenue and Cost Functions Foundation Microeconomics Part 1 of 3

Profit Maximisation

Profit Maximisation: the price and output levels that would yield the greatest profits. Occurs when; Marginal cost = Marginal Revenue

If;

MR > MC; can make more profit by producing more; thus raise output

MR < MC; making a loss on additional units sold; thus reduce profit

MR = MC; any change from this point will cause a reduction in profit; stay at this level of output

Page 21: Theory of the Firm : Revenue and Cost Functions Foundation Microeconomics Part 1 of 3

Profit Maximisation

MR

MC

Costs/Revenues

Quantity

Page 22: Theory of the Firm : Revenue and Cost Functions Foundation Microeconomics Part 1 of 3

Key Concepts• Costs: Fixed, Variable, Total, Average,

Marginal• Price taker price maker• Profit• Profit maximisation

Page 23: Theory of the Firm : Revenue and Cost Functions Foundation Microeconomics Part 1 of 3

KEY CONCEPTS• Economies of Scale• Diseconomies of Scale• Impact of technology on firms

Page 24: Theory of the Firm : Revenue and Cost Functions Foundation Microeconomics Part 1 of 3

Theory of a Firm: Economies of ScaleEconomies of Scale: cost advantages obtained due to business

expansion. If a firm is experiencing an increase in economies of scale; as output increases average costs per unit decrease.

Diseconomies of Scale: as output increases, average costs per unit increases

Page 25: Theory of the Firm : Revenue and Cost Functions Foundation Microeconomics Part 1 of 3

OutputO

Co

sts

LRACEconomiesof scale

Constantcosts

Diseconomiesof scale

A typical long-run average cost curveA typical long-run average cost curve

Page 26: Theory of the Firm : Revenue and Cost Functions Foundation Microeconomics Part 1 of 3

Economies of Scale

Factors that can lead to Economies of Scale

• Indivisibilities - large scale production uses more efficient techniques

– central office and other functions– minimum efficient size of production lines– Research and Development

• Specialisation - division of labour, especially production lines; specialised departments - accounts, personnel, production etc.

Page 27: Theory of the Firm : Revenue and Cost Functions Foundation Microeconomics Part 1 of 3

Economies of Scale• Expansion of Capacity

• More scope to meet unexpected contingencies - better experience.

• Inventories are smaller % of production

• Creation of transport and distribution networks

Page 28: Theory of the Firm : Revenue and Cost Functions Foundation Microeconomics Part 1 of 3

Economies of Scale• Financial

• Loans, market power, bulk buying of raw materials, advertising

• Improve contracts with suppliers• Selling and Marketing

• Improved capital and experience for advertising

• Creation of brand images, improved brand awareness

Page 29: Theory of the Firm : Revenue and Cost Functions Foundation Microeconomics Part 1 of 3

Economies of Scale• Sunk costs - once plant is installed, the opportunity cost of its

continued use may be very low. This gives ‘larger’ existing producers a cost advantage over new entrants.

• Central management organisation is of the nature of a one-off cost

• Spreading of risk - multi-product firms,

• may be able to force down labour costs

Page 30: Theory of the Firm : Revenue and Cost Functions Foundation Microeconomics Part 1 of 3

Diseconomies of Scale

• Ineffective Management

• Poor Communication

• Lack of effective knowledge and lack of building on experience